The US wireless telecommunications industry is worth more than $150 billion and the industry as such employs about 3.8 million individuals directly or indirectly. There are four major players in the wireless telecommunications industry - AT&T, Verizon Communications, Sprint Corporation, and T-Mobile US. AT&T is by far the largest of them in terms of market capitalization and firm value. As of 13th September 2013, AT&T has a market capitalization of $180.41 billion and an enterprise value of $248.8 billion. The company is also largest in terms of revenue generation with revenues of about $127.5 billion for the financial year ending 2012. However in terms of number of customers, Verizon leads the race with 108.7 million customers followed by AT&T with 103 million. Sprint caters to 55 million customers and T-Mobile caters to 33.73 million customers. The industry once dominated by AT&T has come a long way as today internet connectivity is built into appliances, utility grids, electronic equipment, and buildings. As a result new technology solutions are emerging in sectors such as Healthcare, Energy, Transportation, Education, and e-commerce. This has opened up quite a few avenues for the wireless telecommunications industry. Today the global internet network connects the major cities in the US with business hubs in the Europe and Asia with networks that can deliver speeds up to 100 Gbps (Gigabytes per sec). The industry has moved a long way from the traditional copper network, speed and bandwidth constraints to LTE (Long Term Evolution) network. Verizon as of the second quarter of 2013 has covered the entire US population with 4G LTE and has span the entire 3G footprint, the previous generation spectrum. As of the year 2012, the smart phone penetration in the US has been close to 58% and Verizon has about 40 4G LTE enabled smart phones, tablets, and internet devices.
Between 2000 and 2013, US population has grown by 11.2% reaching 314 million in 2012. But the year on year population growth rate averaged only about 0.9%. 20% of the population is below 18 years old, 67% of the population lies in the age group of 18 to 64, and about 13% of the population is above 64 years old. This demographics one hand offers challenges to the telecommunications industry that the growing population will lead to reduction in demand however on the other hand, older population also will result in demand for other services to which wireless and wire-line telecommunications cater to such as the Healthcare. In addition, Increasing age of the population also brings increased care and thus increasing cost. So sectors such as Healthcare are looking for ways in which they can offer quality care at a reasonable cost.
Today, an average US household has at least seven devices and so bandwidth and speed have become the call of the day. As of 2011, average price per minute in the US costed about $0.049 as against $0.167 in the Europe. With increasing demand, there has also been pressure on the cost of service. As a result, although the revenue per customer has remained pretty much stable, the cost of maintaining and providing value added services to retain the customer is being challenged. For the year ending 2012, the revenue per customer for AT&T was $1237, $1064 for Verizon, and $644 for Sprint. However the operating income per customer varied across these players - AT&T had an operating income per customer of $126, followed by $151 for Verizon, and Sprint actually reporting operating losses. To counter these imbalances, organizations such as Verizon have been diversifying in new growth avenues and improving on the operating margins. In spite of recession and increasing cost pressures, between 2009 and 2012, Verizon was able to increase its revenue per wireless connection by 6.5% and reduce the cost of serving the customer by about 17.3%. In addition, the company has engaged in partnerships with nation's major cable companies to deliver video solutions on a national scale across 4G LTE wireless and cable networks. The company identifies that digital healthcare and mobile health platforms is one of the future growth potentials and is investing in R&D while partnering with entrepreneurs and other computing technology firms in areas such as cloud computing.
Earlier this month, Verizon announced that it would be buying the 45% stake that Vodafone has in the Verizon Wireless for $130 billion. This is the third largest deal in the corporate history. Start of this year, Verizon offered $100 billion for the 45% stake and Vodafone board felt that the wireless division was valued much beyond this. The deal was announced on the 6th of September 2013 and on the 9th of September, a Verizon shareholder sued the company stating that the price it is paying is too high. If Verizon was wanting to pay $100 billion at the start of this year, then it must have valued the business unit (Verizon Wireless) at $222 billion. So what makes Verizon change its stand and pay Vodafone a whooping $130 billion resulting in a value of $289 billion for Verizon Wireless.
- Verizon communications Inc is a wireless and wire-line communications company incorporated in the US. The company is listed on the New York Stock Exchange and has a market capitalization of $135.5 billion. For the year ending 2012, Verizon reported an operating revenue of $115.65 billion with an operating profit of $20.7 billion (excluding non recurring items). As of 2012, Verizon is the largest telecommunications player in the US in terms of number of customers. Between 2008 and 2012, the company has grown its revenue by 23.5% despite recession. Between this period, year on year revenue growth averaged 5.4%. During this period, the company also invested in both tangible and intangible assets and as a result, the fixed assets of the company increased by 23% to reach $196.5 billion. For the year 2012, Verizon registered a ROA of 4.42% and a ROE of 13.99%, much above its competition (AT&T reported a ROA of 2.82% and a ROE of 7.98%, Sprint reported a ROA of 0.99% and negative returns to equity, and T-Mobile reported a ROA of 2.3% and negative returns to equity). This just goes to show that Verizon has sound financials relative to the industry.
- However the composition of the revenue and operating income of the company brings new dimension and to a large extent substantiates reasons for why Verizon is eager to buy back the 45% share held by Vodafone. Verizon Communications Inc constitutes two separate business units - the traditional wire-line division and the wireless division (Verizon Wireless) that was formed in June 2000 as a merger of Verizon (55%) and Vodafone (45%). Between 2008 and 2012, the contribution from Verizon wireless to the total revenue of the company (Verizon Communications) increased from 52.6% to 65.6% to reach $75.9 billion. During this period, operating income from wireless segment increased by 55.9% to reach $21.7 billion (excluding extraordinary items) where as operating income from wire-line segment decreased by 98% to reach $60 million (excluding extraordinary items).
- The wireless segment constitutes of pre-paid and post-paid connections. The post-paid connections as a percentage of total wireless customers is about 94% (remained stable between 2009 and 2012). As of 2012, the total number of retail connections reached 98 million (crossed 100 million in the second quarter of 2013). Between 2008 and 2012, The number of retail connections has grown by 40% to reach 98.2 million as against 53.9% increase in revenue thus indicating that the company was probably able to charge a price premium for this segment.
- On the other hand the wire-line segment constitutes voice connections, broadband connections, fiber optic internet and video subscribers. The fiber optic internet and video subscribers contribute to about 60% of the total revenue generated by this segment although they only constitute 25% of the total customer base in this segment. As a result, there is a huge cost to benefit disparity in this segment. Between 2008 and 2012, the number of fiber optic internet and video subscribers increased 1.4 times to reach 10.2 million and the revenues increased by 47.7% to reach $23.1 billion in 2012. On the contrary the voice and broadband has been doing very bad. These services include voice service over long distance, broadband video and data, IP network services, network access, etc. Revenue from these services has actually fallen by 37% between 2008 and 2012. Part of the reason could be that there has been migration happening between wire-line and wireless segment and so there must be a few customers who must have moved from wire-line to tap in to the wireless services.
As a result of above performance, Verizon has realized that its growth potential lies in wireless and fiber optics although they cannot do away with the voice and broadband. However with the joint venture with Vodafone (which states that Verizon will pay Vodafone 45% of the net income generated from the wireless segment excluding all the extraordinary items), the Net income that went towards non controlling stake (income that needs to be paid to Vodafone) increased from 58% in 2009 to 92% (of the company net income that includes both wireless and wire-line combined) reaching $9.7 billion in 2012. As a result, the operating cash flow that would otherwise be available for Verizon to expand was being challenged by this agreement. The above growth story in the wireless segment and dwindling incomes from the wire-line segment explains why Verizon is more keen today than it was earlier in getting this deal done. So this largely answers one part of the story as to why Verizon is so keen in pushing this deal through although the price it paid increased from $100 billion at the start of this year to $130 billion when it closed the deal this month (September). However it is also important to know if Verizon paid the right price. This post though will not answer the question as to whether Verizon paid the right price however it will give you some insight in to how long it is likely to take for Verizon to break even on this deal. It is then left to the audience to decide whether this is an appropriate deal or not!
- The $130 billion that Verizon needs to pay Vodafone is being funded by $58.9 billion in cash, $60.2 billion in Verizon stock, and $5 billion in loan notes and other considerations. As on 2012, Verizon has a long term debt of $51.2 billion and approximately, it pays an interest on this debt at a pre-tax rate of 5% per year. In addition, for this current deal, Verizon has tapped the credit markets to raise an additional $49 billion. This makes the total long term debt equivalent to $100 billion. Besides, Verizon is likely to go for bridge financing up to $11 billion, which will be paid from smaller transactions resulting from a deal that is likely to close by first quarter of next year. Since the deal does not include any exchange of equity, the market capitalization of the company will not be impacted. The deal just ensures that Verizon no longer has an obligation to service the joint venture. So this means that the present value of future cash flows (resulting from this 45% of the net income generated by the Wireless segment) should be greater than $130 billion. In order to understand this scenario, we calculated the WACC for the company. As the market capitalization is unlikely to change but the total debt position has for sure changed as on date (13 Sept 2013), we used this updated numbers to arrive at the cost of equity and cost of debt. The price of risk (Beta) was calculated using multiple linear regression however after adjusting to the stock splits that have taken place in the interim. The weighted average cost of capital (WACC) for Verizon was 4.73%. This is not unusual for a large company with such a large debt component and equivalently proportional equity.
- As per the market statistics, Verizon covers about 36% of the US population followed by AT&T with 34%. US population has been increasing at a rate of 0.89% year on year between 2000 and 2012. In addition, on an average between 2007 and 2012, there were about 1 million legal immigrants residing in the US. So besides migrating customers from one segment to another segment, taping into new generation of advanced electronics and medical devices with LTE connectivity, and Fiber optics, Verizon could tap in to the new immigrants who arrive in to the country and also increasing its offerings in the space of fiber optics and wireless communications. Based on the past performance (average revenue growth year on year between 2008 and 2012 was about 5%), competition (Qualcomm is another serious player in the mobile health platforms besides AT&T, and Verizon), adaptability of these rising sectors to the technologies offered by the wireless telecommunications industry, we feel that Verizon will grow by 5% year on year for the next five years, then the company would have grown too large to grow at the same pace so the growth rate is likely to be around 3% till 2023 and then on the company will grow at the same rate as GDP of the economy so we have considered that to be about 2.5%. We do understand that in any discounted cash flow, growth rates do make a huge difference in valuation however for a company as large as Verizon, we feel the growth rate projection will hardly deviate by a few basis point as against our prediction.
Based on the WACC, growth rate, and the free cash flow calculated using the growth rate, the present value of cash flows generated between 2014 and 2033 is $131.3 billion. This indicates that it is likely to take 20 years for Verizon to break even on this deal. However the free cash flows considered while arriving at this present value constitute - the wire-line segment, the 55% stake that Verizon Communications holds in Verizon Wireless, and the 45% stake that Vodafone holds in Verizon Wireless. In order to truly understand the value of this deal, the free cash flows have to be derived just from the 45% that Verizon is currently buying from Vodafone. Due to limitations of information availability, we many not be able to arrive at a present value number however we can confidently conclude that it is going to take Verizon more than 20 years to break even on this deal and the conclusion is based on the present value number that was arrived at using the company wide free cash flow projection. So it seems like the concern raised by the shareholder to some extent remains valid. However from Verizon point of view, it does give the company a lot more freedom in terms of cash flow available for exploring new avenues, investing in R&D, and fostering growth. We now leave it to the audience to decide whether you are fine with a break even in 20 + years. While making your judgement, please bear in mind that we are not looking at a small or a mid cap company. Here is a company with a market capitalization of about $133 billion and a revenue base of about $115 billion and covers more than a third of US population!
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